Tax Evasion and the Incidence of Capital Taxation

This paper studies how endogenous tax compliance changes the incidence of capital taxation when households earn heterogeneous returns. I develop an incomplete-markets heterogeneous-agent model in which households save, invest in entrepreneurial activities, and can conceal capital-side tax liabilities. Disciplined by U.S. evidence, the model quantifies how concealment creates a wedge between statutory and effective capital taxation and how this wedge interacts with return heterogeneity, the statutory tax rate, and the choice of tax base. Changing the tax base generates a substantial endogenous compliance response: replacing the capital-income tax with a revenue-equivalent wealth tax reduces the liability-weighted concealment rate from 15.9% to 3.3% and raises long-run welfare. The difference between statutory and effective taxation also becomes increasingly important at high capital-income tax rates. At a 40% statutory rate, output is nearly 7% higher with endogenous evasion than under perfect compliance, while capital-tax revenue is about one third lower. Finally, transition dynamics under a balanced-budget fiscal closure reveal a distinct fiscal-timing margin. Abolishing capital-income taxation raises long-run welfare but lowers welfare of households alive at implementation, whereas the wealth-tax replacement raises welfare both at implementation and in the long run. The incidence of capital taxation therefore depends jointly on statutory tax policy, endogenous compliance, and the dynamics of fiscal adjustment.